Wednesday, July 26, 2006

Still Watching the Data, by Tim Duy:
Futures markets
appear to have no clear conviction on the outcome of the next FOMC meeting. The
message is that market participants are looking for one more rate hike, either
in August or September. Moreover, they doubt the Fed’s position that “pause does
not mean done.” That’s one of the messages from Jim Hamilton’s
exposition on the yield curve.
In fact, not only do market participants expect the next hike to be the last,
they anticipate that the Fed will soon be rolling back the rate hikes.

The argument for another rate hike in August is straightforward – sure the
economy is slowing, but is it slowing enough given that it is already bumping up
against resource constraints? Moreover, with core-CPI posting four consecutive
0.3% readings, policymakers will appear to be accommodating higher inflation by
failing to match it with higher interest rates, and thus will be setting the
stage to fuel expectations of higher inflation. This essentially forms the
backbone of my
sense last week that the Fed was more likely
than not to hike rates in August before pausing.
The most recent employment, CPI, and industrial production reports, in my
opinion are supportive of that position.

The counter-argument is that with the economy showing visible signs of
slowing, particularly the combined housing/consumer sector, we are at an
inflection point that calls for additional caution on the part of the Fed.
Indeed, the composition of growth appears to be shifting in line with former Fed
Chairman Alan Greenspan’s expectations. Consumer spending is easing, but
investment spending is holding up while the external sector looks poised
to contribute positively to GDP growth. The durable goods and GDP reports will help
confirm or deny these trends.

Ultimately, the decision will rest on the forecast for inflation. And here,
as many have pointed out, the housing story appears to cut both ways. Will the
Fed be concerned about slowing housing activity, or the resulting inflationary
impact via measurement issues?

I am not particularly sympathetic to the notion that the BLS consistently
underestimates inflation by the use of owner occupied rent (OER) as a measure of
housing costs. This would be an error if consumers thought of their homes as
purely “shelter,” but they do not. If they did, they would not be so willing to
pay a premium for owner-occupied housing relative to the rental alternatives.
Instead, consumers view their homes as part shelter and part investment. It is
perfectly reasonable for an index of consumer prices to simply focus on the
shelter part of the consumer’s decision.

Of course, there is a reasonable position that argues that central banks
should have a broader definition of price stability, one that includes asset
prices as well as consumer prices. This would be the proper place to address the
issue of house prices and monetary policy. In other words, the debate is not
whether the BLS is accurately estimating inflation. The debate is really about
what measure of prices the central bank should monitor, a narrowly defined
consumer measure (that excludes food and energy) or a broad measure that
includes asset prices.

I am also not particularly sympathetic to the latter position – I tend to
believe it provides the central bank with too much influence in directing
capital allocation decisions. Still, I recognize the opinions of those who
believe that capital was essentially wasted during the internet bubble or, more
recently, by excessive investment in residential housing. Note that the “waste”
was likely greater in the former due to the more rapid depreciation of
technology.

In any event, it appears clear that dynamics in the housing market helped
depress measured consumer inflation until recently and now those same forces are
working against the data. If the Fed were to be consistent, then they would not
discount the inflationary impulse of rising OER. Indeed, they seemed perfectly
happy with the inflation figures that were depressed by low OER growth.
According to
John Berry,
however, consistency is not the order of the day:

Even if rents aren't the only issue, the causes of why they are rising so
much mean that Fed officials do regard them somewhat separately from the other
inflationary pressures at work. Essentially, the surge in rents is seen as a
transitory phenomenon that will ease gradually.

This will appear to many to be
gross cherry picking of the data,
while others will be content to know that the Fed is carefully considering the
data rather than reacting in a knee-jerk reaction to the inflation numbers. In
any event, it would answer another question that had been posed to me: Why does
the Fed expect core inflation to eventually moderate when growth is only
expected to slow to potential, not below potential? They do see at least one
component as separate from cyclical forces, and thus are more sympathetic to a
pause in August then one would think given the recent run in the inflation
figures. Still, I am not sure how far to carry this line of thought – as Berry
noted, Fed Chairman Ben Bernanke clearly said that OER is not the only factor
driving the rise in core inflation.

Also, John Berry describes the Fed’s thoughts about as “…probably their
greatest single worry about growth right now.” I find this comforting, and would
represent a clear shift in thinking at the Fed since this spring, when I noted:

From
MarketWatch:
“Poole said the financial press puts to much focus on "highly visible" sectors
like the housing sector, even though it only amounts to a small fraction of
overall GDP growth.”

In other words, I felt the Fed was discounting the housing slowdown,
threatening to reveal that little had been learned from the Nasdaq meltdown.
Clear evidence of a shift in consumer spending that coincides with a growing
housing slowdown may be prompting a fresh look at the importance of the housing
market on Constitution Ave. – another reason to look for a pause.

Likewise, on balance, I would have to place the most recent
Beige Book in
the “pause” column. Indeed, the collection of anecdotal evidence almost mirrors
exactly the soft landing scenario: In general, economic activity is slowing on
the back of weakening consumer spending and housing activity, but manufacturing
activity remains solid, particularly for durable goods:

Among products, demand was especially vigorous for various durable goods.
Substantial sales gains were reported for makers of electrical equipment and
information technology products such as semiconductors, along with further
increases in orders and activity for makers of commercial aircraft and products
used for national defense. The reports also pointed to a further rise in demand
for makers of heavy equipment, machine tools, and steel, offset in part by
reduced demand for smaller equipment that is oriented towards residential
construction activity.

In addition, intense competition and, in Dallas weaker demand, is holding
back inflationary pressures. More “hawkish” FOMC members may seize upon
“scattered indications of faster growth for some workers,” but their concerns
will be tempered by more “dovish” members pointing out high productivity
(meaning low unit labor cost growth).

Bottom line: The outcome of the August meeting still looks like a tossup,
with current inflation data in competition with the magnitude of the slowdown.
After being shocked by the forcefulness of the
Fed’s inflation rhetoric in early June,
I have been hesitant to move back to the “growth slowdown argues for a pause”
story. Of course, that may be what exactly what Fed officials wanted to
accomplish: To firmly establish their inflation fighting credibility before they
take the long awaited pause.

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Fed Watch: Still Watching the Data

Tim Duy with a Fed Watch:

Still Watching the Data, by Tim Duy:
Futures markets
appear to have no clear conviction on the outcome of the next FOMC meeting. The
message is that market participants are looking for one more rate hike, either
in August or September. Moreover, they doubt the Fed’s position that “pause does
not mean done.” That’s one of the messages from Jim Hamilton’s
exposition on the yield curve.
In fact, not only do market participants expect the next hike to be the last,
they anticipate that the Fed will soon be rolling back the rate hikes.

The argument for another rate hike in August is straightforward – sure the
economy is slowing, but is it slowing enough given that it is already bumping up
against resource constraints? Moreover, with core-CPI posting four consecutive
0.3% readings, policymakers will appear to be accommodating higher inflation by
failing to match it with higher interest rates, and thus will be setting the
stage to fuel expectations of higher inflation. This essentially forms the
backbone of my
sense last week that the Fed was more likely
than not to hike rates in August before pausing.
The most recent employment, CPI, and industrial production reports, in my
opinion are supportive of that position.

The counter-argument is that with the economy showing visible signs of
slowing, particularly the combined housing/consumer sector, we are at an
inflection point that calls for additional caution on the part of the Fed.
Indeed, the composition of growth appears to be shifting in line with former Fed
Chairman Alan Greenspan’s expectations. Consumer spending is easing, but
investment spending is holding up while the external sector looks poised
to contribute positively to GDP growth. The durable goods and GDP reports will help
confirm or deny these trends.

Ultimately, the decision will rest on the forecast for inflation. And here,
as many have pointed out, the housing story appears to cut both ways. Will the
Fed be concerned about slowing housing activity, or the resulting inflationary
impact via measurement issues?

I am not particularly sympathetic to the notion that the BLS consistently
underestimates inflation by the use of owner occupied rent (OER) as a measure of
housing costs. This would be an error if consumers thought of their homes as
purely “shelter,” but they do not. If they did, they would not be so willing to
pay a premium for owner-occupied housing relative to the rental alternatives.
Instead, consumers view their homes as part shelter and part investment. It is
perfectly reasonable for an index of consumer prices to simply focus on the
shelter part of the consumer’s decision.

Of course, there is a reasonable position that argues that central banks
should have a broader definition of price stability, one that includes asset
prices as well as consumer prices. This would be the proper place to address the
issue of house prices and monetary policy. In other words, the debate is not
whether the BLS is accurately estimating inflation. The debate is really about
what measure of prices the central bank should monitor, a narrowly defined
consumer measure (that excludes food and energy) or a broad measure that
includes asset prices.

I am also not particularly sympathetic to the latter position – I tend to
believe it provides the central bank with too much influence in directing
capital allocation decisions. Still, I recognize the opinions of those who
believe that capital was essentially wasted during the internet bubble or, more
recently, by excessive investment in residential housing. Note that the “waste”
was likely greater in the former due to the more rapid depreciation of
technology.

In any event, it appears clear that dynamics in the housing market helped
depress measured consumer inflation until recently and now those same forces are
working against the data. If the Fed were to be consistent, then they would not
discount the inflationary impulse of rising OER. Indeed, they seemed perfectly
happy with the inflation figures that were depressed by low OER growth.
According to
John Berry,
however, consistency is not the order of the day:

Even if rents aren't the only issue, the causes of why they are rising so
much mean that Fed officials do regard them somewhat separately from the other
inflationary pressures at work. Essentially, the surge in rents is seen as a
transitory phenomenon that will ease gradually.

This will appear to many to be
gross cherry picking of the data,
while others will be content to know that the Fed is carefully considering the
data rather than reacting in a knee-jerk reaction to the inflation numbers. In
any event, it would answer another question that had been posed to me: Why does
the Fed expect core inflation to eventually moderate when growth is only
expected to slow to potential, not below potential? They do see at least one
component as separate from cyclical forces, and thus are more sympathetic to a
pause in August then one would think given the recent run in the inflation
figures. Still, I am not sure how far to carry this line of thought – as Berry
noted, Fed Chairman Ben Bernanke clearly said that OER is not the only factor
driving the rise in core inflation.

Also, John Berry describes the Fed’s thoughts about as “…probably their
greatest single worry about growth right now.” I find this comforting, and would
represent a clear shift in thinking at the Fed since this spring, when I noted:

From
MarketWatch:
“Poole said the financial press puts to much focus on "highly visible" sectors
like the housing sector, even though it only amounts to a small fraction of
overall GDP growth.”

In other words, I felt the Fed was discounting the housing slowdown,
threatening to reveal that little had been learned from the Nasdaq meltdown.
Clear evidence of a shift in consumer spending that coincides with a growing
housing slowdown may be prompting a fresh look at the importance of the housing
market on Constitution Ave. – another reason to look for a pause.

Likewise, on balance, I would have to place the most recent
Beige Book in
the “pause” column. Indeed, the collection of anecdotal evidence almost mirrors
exactly the soft landing scenario: In general, economic activity is slowing on
the back of weakening consumer spending and housing activity, but manufacturing
activity remains solid, particularly for durable goods:

Among products, demand was especially vigorous for various durable goods.
Substantial sales gains were reported for makers of electrical equipment and
information technology products such as semiconductors, along with further
increases in orders and activity for makers of commercial aircraft and products
used for national defense. The reports also pointed to a further rise in demand
for makers of heavy equipment, machine tools, and steel, offset in part by
reduced demand for smaller equipment that is oriented towards residential
construction activity.

In addition, intense competition and, in Dallas weaker demand, is holding
back inflationary pressures. More “hawkish” FOMC members may seize upon
“scattered indications of faster growth for some workers,” but their concerns
will be tempered by more “dovish” members pointing out high productivity
(meaning low unit labor cost growth).

Bottom line: The outcome of the August meeting still looks like a tossup,
with current inflation data in competition with the magnitude of the slowdown.
After being shocked by the forcefulness of the
Fed’s inflation rhetoric in early June,
I have been hesitant to move back to the “growth slowdown argues for a pause”
story. Of course, that may be what exactly what Fed officials wanted to
accomplish: To firmly establish their inflation fighting credibility before they
take the long awaited pause.